Monthly Archives: November 2012

Defenders of the OTC swaps model like to talk a lot about the ability to custom tailor the terms of a swap to each customer’s particular needs, and also about the room given to innovate new product designs. The listed futures exchange model cannot accommodate this degree of innovation and customization. That’s true, as far as it goes.

Fortunately, the Dodd-Frank OTC derivative reforms preserve a space for this element of the OTC swaps model. Customized swaps are still allowed. Swaps that implement new product designs are still allowed. Exchange trading is not mandatory for all swaps. Clearing is not mandatory for all swaps.

When we talk about futurization of swaps, we are talking about the larger subset of swaps that are either already marketed as off-the-rack products, or that can be easily repackaged as such. This represents the vast majority of OTC swap trading.

Dodd-Frank was architected to allow standardized derivative trading either on the newly created swap exchanges or on the pre-existing futures exchanges. The current talk about futurization is all about the choices being made for trading these standardized derivatives. Instead of transitioning onto swap exchanges, they are moving out of the swaps marketplace and onto the futures marketplace. Customized derivatives will have to continue to be offered as swaps, which Dodd-Frank explicitly allows.

Moving standardized derivatives onto exchanges, and clearing those transactions can benefit customers. There is a lot to be gained from encouraging efficiency and product development in ready-to-wear derivatives.

Artisinal production has its benefits, but mass production does, too. The Dodd-Frank reform permits both.

Share this:

The trial of UBS trader Kweku Adoboli ended yesterday with his conviction on two counts of fraud and the dismissal of the accounting allegations. Some news accounts have noted that testimony at the trial also exposed embarrassingly shoddy risk management at UBS. Prop-flow also stands convicted.

Prop-flow is one of those wonderful neologisms of the investment banking world. UBS’s Delta One desk, where Kweku Adoboli was employed, is a classic example of the prop-flow trading model. Ostensibly, a Delta One desk is serving customers, manufacturing risk exposures that the clients want, and earning revenue for providing that service. But the testimony at Adoboli’s trial leaves no doubt that his assignment was proprietary trading, pure and simple. He wasn’t convicted because he did prop trading, but because of how he did his prop trading. The testimony leaves no doubt that his UBS managers always expected him to be placing proprietary trading bets. The only dispute was about how those bets were managed and recorded, and the scale of the bets along the way.

How much tolerance bank Boards of Directors and bank regulators have for neologisms like prop-flow will be an important question in the coming years as the Volcker Rule and similar prohibitions come into force.

Share this:

The SEC is currently considering whether to allow JP Morgan and Blackrock to list new copper ETF’s on the NYSE Arca. Some copper industry players oppose the listing, as does U.S. Senator Carl Levin and the advocacy group Americans for Financial Reform. Comment letters can be found here. Earlier this month, SEC Staff in the Division of Risk, Strategy, and Financial Innovation filed a memo reporting its empirical analysis that downplays any potential problem. That memo is a testament to how America’s financial regulators too often fail in their duty to protect the sound functioning of US financial markets.

The SEC staff asks two narrow questions.

First, is there a simple and enduring mechanical link between the flow of money into a commodity ETF and the price of copper. They answer, ‘no.’

Second, is there a simple linear relationship between copper inventories and copper prices. Again, they answer, ‘no.’

The Staff’s analysis is faulty in many ways. Both industry players and the advocacy group Americans for Financial Reform filed careful, detailed critiques of the econometrics and reasoning. These are well worth reading, and thoroughly impugn the soundness of the Staff’s conclusions.

What alarms me most is the narrow scope of the questions that the Staff posed, even had they bothered to do a thorough analysis of those questions. A proper regulator needs to assure that the market functions well. There are any number of ways in which its operation can be disrupted. We have a long, long history of commodity markets in the US, and that means we have a long history with market manipulation and other price distortions. We have a long, long history with financial markets in the US, and that means we have many experiences with asset bubbles, especially in the recent past with the dotcom and housing bubbles, as well as the oil price bubble. Neither of the two empirical tests the SEC Staff examined touches in any way on the issues one would want to examine in order to assure the sound functioning of the copper market and the healthy contribution that financial trading could make to the market. The mechanical link the Staff searched for would not show up in a market rife with manipulation. Nor is that mechanical link necessarily symptomatic of an asset price bubble. So failing to find such a link provides no assurances that this market will function properly. And it is alarming that the SEC Staff does not explore any of these other important issues that must be settled. Just as the SEC Staff did in the Madoff case, it carefully asks the wrong questions and thereby comes to easy answers.

Personally, I’m confident that financial markets have a valuable contribution to make in extending the efficiency and productivity of the real economy. I believe that’s true for all commodity markets as well, copper included. But making that happen requires active engagement by US regulators, and not a ‘see no evil’, hands off, laissez faire approach. That way lies market disruption and an undermining of the productivity of the economy.

Futurization is the movement of derivative trades out of the OTC swaps marketplace and into the futures marketplace. There are different ways in which this shift may take place. Economically, they all have one thing in common: a recognition that there is in fact nothing special about swaps as a financial instrument. In general, any package of risk that can be structured via a swap can also be structured using futures and options contracts that can be traded in the futures marketplace.

The essential distinction between the OTC swaps marketplace and the futures marketplace is the regulatory rules, not the product designs that can be offered. Of course, a difference in regulatory rules can be economically significant, too. But it is important to keep straight the real source of any economic impact.

Prior to the Dodd-Frank Act, the OTC swaps marketplace lacked regulatory oversight, transparency and clearing, and the vast majority of derivative trades were executed in this marketplace as a result. After the Dodd-Frank Act, all OTC swaps trades are subject to regulatory oversight, and the vast majority must be traded transparently and cleared. There are exceptions that allow the OTC swaps market to continue offering swaps that are custom designed, and therefore ill-suited to exchange trading and clearing. However, for the vast majority of swaps, the Dodd-Frank Act removed the main advantage of the OTC swaps marketplace. With the mandates of oversight, transparency and clearing, the main raison d’être is gone.

Consequently, all players in the industry are now reassessing the choice of venue for derivatives trades: the OTC swaps market or the futures market. When the new calculus leads them out of swaps and into futures, that is the essence of the futurization of swaps.

How is the futurization of swaps to take place? I group the different ways into two main categories.

First, in many cases, plain vanilla futures and option contracts can easily substitute for swaps.

This is exemplified by the recent decision by the ICE to simply switch its cleared energy swaps into futures contracts. There was more to it than simply changing the package label, but not much more. ICE’s cleared energy swaps may be a special case for the ease with which such a transition can be executed, but from an economic standpoint it is much more representative than is yet widely recognized.

The vast majority of interest rate and foreign exchange swap transaction could be readily supplanted by plain vanilla futures and option contracts, as can other commodity swaps. For example, the CME’s IMM has long offered interest rate and currency futures which serve the same risk packaging function as interest rate and currency swaps. But these products were overshadowed by the OTC swaps marketplace because that marketplace had the advantage of not being regulated. Now that the Dodd-Frank Act has imposed comparable regulatory rules which remove the advantage of the OTC marketplace, these products may once again come out from under the shadow of the OTC and steal back the business. That hasn’t happened yet. But be patient.

A second, more contorted category involves attempts to somehow trade swaps, but to do it under the futures regulatory rules. These are the so-called “swap futures”. One example comes from the CME, which, in September, announced plans to launch its interest rate swap futures product. This is a futures contract where the underlying product is a traditional interest rate futures contract. So long as the customer owns the futures contract, the margining and other regulatory rules of the futures exchange apply. But, if the contract is held to delivery, then the customer finds itself holding an OTC swap, and the margining and regulatory rules of the OTC swaps marketplace then apply. Another example comes from the upstart Eris Exchange, which launched its interest rate swap futures product back in 2010. Instead of making the underlying product an actual swap, Eris cash settles its futures product to mimic those on an OTC swap.

This second category has all the buzz, currently. But perhaps not for long. The push for this second category is predicated on the idea that it is possible to have the best of both worlds—the current regulatory arbitrage benefits of the futures marketplace along with the economic advantages of swaps. But there never were any special economic advantages of swaps, so the underlying rationale for swap futures is faulty. After the buzz dies down, and the players recognize the problem, the action may turn back to the first category. On that, we are still waiting. Be patient.

The reform of the derivatives market, like other parts of financial reform, has been a very slow moving process. As when a giant ocean tanker is being slowly turned around, progress is so slow that it can be hard for the naked eye to confirm that the event is actually happening until the great ship’s silhouette overtakes a distinctive landmark on the horizon. And derivatives market reform, too, is happening. Each time the reform slowly approaches a new landmark on the horizon, the fact of reform is confirmed once again to proponents and opponents alike. And each time this happens, there are new howls from opponents that the ship’s current course will surely lead to disaster.

The current occasion for complaints goes under the heading “futurization of swaps.” Pre-reform, derivatives could either be traded in regulated marketplaces, generally called futures markets, or in the un-regulated marketplaces, generally called the OTC swaps market. The Dodd-Frank Act brought regulation to the OTC swaps market. Those regulations are only now beginning to take effect, or the deadlines are approaching. As that happens, companies on all sides of the derivatives markets are beginning to rethink where they should do their derivatives business. Should they continue to trade swaps, or can they get the same result using futures? Should they continue to market swaps, or should they now market futures? The swaps marketplace used to have the advantage of being unregulated, but as that advantage appears to be disappearing, where is the rationale for swaps? Derivative consumers and producers alike are giving the futures markets a fresh look. Some swap products have been relabeled and moved over to futures markets. Other, new futures products are being developed as substitutes for old swap products.

Obviously a major shift of business from the swaps market to futures markets threatens major business interests. Throughout the legislative battles leading up to Dodd-Frank, and the rulemaking and legislative battles surrounding implementation, the big banks that controlled and profited from the OTC swaps market hoped to preserve their monopoly. So far, they have mostly failed. The current debate about the ‘futurization of swaps’ is a major milestone in the process, and it is no surprise that it is raising new howls. These interests are complaining that the legislation is killing the swaps market, ruining a valuable financial innovation.

In the coming days, I will look at various arguments being made against the futurization of swaps. None of them hold up.

Share this:

About this blog

We use this blog to discuss with our students issues in risk management for non-financial corporations. The blog addresses interesting events in the news, as well as advances in financial analysis. We have made the blog public to encourage valuable contributions from former students, colleagues and others in industry, government and academia.

The content of the blog is closely aligned with the material in our lecture notes on Advanced Corporate Risk Management (MIT course 15.423). A website with the notes and associated materials will be coming soon.